Gold/Oil Ratio Extremes 2

The financial markets are endlessly fascinating to study, but it is really
not very often that we are blessed to witness extremes never before seen in
history. Given markets' well-documented abhorrence of extremes and their ironclad
tendencies to mean revert, extremes usually mark stellar trading opportunities.

In late March the venerable gold/oil ratio hit an all-time low, an
abysmal 7.7. The math behind this revelation is simple, it just means that
an ounce of gold now costs only 7.7x as much as a barrel of crude oil, each
priced in dollars. From a speculation perspective however, this never-before-witnessed
extreme has profound implications.

Oil and gold are arguably the most important commodities on the planet today
and the ratio of their nominal prices is far from a trivial issue. The gold/oil
ratio expresses the interrelationship between the commodity that forms the
foundation of our entire global economy and the commodity that has been the
ultimate form of money for six millennia of human history.

Oil, of course, forms the foundation of the extensive global trade today and
hence the world economy. Virtually everything we consume in the first world
is transported via oil-powered ships, trains, airplanes, or trucks. Without
oil, the incredibly intricate global logistics network on which we heavily
rely today would grind to a halt. The world would be thrust back into the Steam
Age before flight and global trade would implode. In this oil-powered young
Information Age, oil truly is the king of commodities.

And gold always has been and always will be the ultimate monetary standard.
Empires and nation states rise and fall, and history is littered with once
mighty fiat currencies that became worthless as their sponsoring governments
slid out of favor. But gold is the standard by which all other currencies are
judged, the only real money of world history. It is highly sought after universally,
it is very scarce in the natural world so its supply can't inflate rapidly,
and it is very valuable relative to the tiny volume it occupies ... the perfect
money.

The gold/oil ratio is such a crucial measure because it expresses the entire
complex interrelationship between the king of commodities and the only timeless
real money in a single data series. This ratio allows us to discern when gold
or oil prices are probably out of whack and hence a mean reversion is highly
likely. If we can figure out which component of this ratio is most likely to
lead this mean reversion, gold or oil, then we can position trades to ride
the move.

I first wrote about this ratio nearly five
years ago, before our secular
gold bull was born. The conclusion I reached back then was that since
the gold/oil ratio was so low (9.2) a mean reversion was probable led by
the gold side of the equation. Gold was trading near $290 at the time and
the gold/oil ratio proved correct in calling gold undervalued.

By last summer the ratio was again running 8.7, even lower, and gold was just
clawing back over $400 following a healthy
correction. In my original
essay in this series I concluded, "Whether oil soars or slumps, a gold/oil
ratio mean reversion is going to push gold higher, probably a whole heck of
a lot higher, in the years ahead." Now, seven months later, the gold/oil ratio
has grown even more extreme at 7.7.

As a student of the markets I have studied mean
reversions extensively, and one of their most intriguing aspects is the
peculiar psychology they generate. In the physical world, the farther something
is stretched the more likely it will fail and everyone intuitively knows
this. But in the investment world, however, the popular perception is that
the farther something is stretched the more likely that it will continue
stretching even further, happily on into infinity.

If you stretch a rubber band between your hands, and pull them apart from
an inch to a foot, does this successful initial stretch make it more or less
likely that the rubber band can continue stretching to three feet? The obvious
answer is less likely, as the greater an extreme placed on a mechanical system
the more likely it is going to catastrophically fail and mean revert to relieve
the excessive energy.

Contrary to popular perception the markets work the same way. The more
extreme something gets, like the NASDAQ bubble of early 2000, the more likely
it is to fail catastrophically as prices mean revert back to historical
norms. But investor psychology is based on inertia, not logic. People perceive
that the greater a market extreme grows the more likely it is to persist forever.
They foolishly believe that each new extreme marks a brave "New Era" where
historical laws of finance no longer apply.

In the case of the gold/oil ratio, similar inertia-based assumptions are gaining
ground today. They are usually directed at the gold side, since global gold
supply and demand is far more murky and difficult to analyze than the global
oil supply and demand. Lots of investors today, for reasons running the gamut
from government conspiracy theories to deflation scares, are advancing the
view that the gold bull is over regardless of the state of the oil bull.
In other words, a permanent new era of extremely low gold/oil ratios is miraculously
upon us!

Is this time really different? Can the oil bull continue migrating higher
in the years ahead while gold languishes driving the gold/oil ratio to new
lows? I doubt it. Rock-solid historical relationships established over 40 years
between gold and oil will not be easily broken. And market history is
crystal clear in teaching that investors would be better off believing in tooth
fairies than the idea of fanciful New Eras exempt from the venerable laws of
finance.

Before we dive directly into the gold/oil ratio analysis to investigate the
probable mean reversion, I would like to briefly discuss this chart of real
inflation-adjusted oil and gold prices. It is a fascinating chart we have been
watching for over five years now and is absolutely crucial foundational background
for understanding the gold/oil ratio.

I find this chart endlessly fascinating on multiple fronts. Perhaps the most
obvious is the fact that oil is just mid-priced and gold is very cheap when
the relentless erosion of the US dollar's purchasing power via the Fed's endless
fiat inflation is factored in. In order to get to new all-time real highs,
oil would have to catapult north of $95 per barrel and gold would shoot well
over $1600.

Neither oil nor gold should be considered expensive today in light of history,
regardless of Wall Street's incessant anti-commodity propaganda. Oil is just
above its First Gulf War spike but still well below its high real levels
from 1980 to 1985 or so. Meanwhile gold is so darned low in real terms that
it hasn't even returned to mid-1990s levels yet! The folks who claim
gold is expensive apparently don't understand inflation.

Second, note the incredible correlation between gold and oil prices in the
last four decades. While they don't always move in lockstep over the short
term, they always seem to ultimately walk hand and hand over the long term.
And, since both the oil and gold axes are zeroed in this monthly chart, the
percentage moves in gold and oil are very similar. This strong dance between
oil and gold is what makes the gold/oil ratio so valuable.

Now since their respective real secular monthly bottoms, $13 for oil
in December 1998 and $284 for gold in March 2001, there has been a massive disconnect.
The oil price has rocketed 312% higher in real terms while gold is only up
a fraction of this, 49% real. Gold's recent lagging is very apparent visually
as well, if you compare the slope of gold and oil since 2000 or so. This anomaly
has created the new all-time lows in the gold/oil ratio.

By definition an anomaly is a deviation from a normal condition, and it is
usually temporary in duration. Gold and oil do tend to disconnect on
occasion. For example, from 1975 to 1980 oil gradually meandered higher while
gold initially fell sharply, throwing the gold/oil ratio out of whack to its
third lowest level ever, 8.2. Yet, this temporary anomaly did not herald the
end of the gold/oil ratio. Soon gold started rallying with oil and caught up
with the black goo with a vengeance by 1980.

Today we may very well witness a repeat of history, of oil driven higher by
strong global supply and demand forces while the gold price initially languishes.
But once investors around the world start to perceive the stunning opportunities
for a mean reversion here, capital will flood into gold and blast it higher
to catch up with oil. Once this current gold/oil ratio anomaly is resolved,
I suspect gold investors will be very happy campers.

Our next chart outlines the fabled gold/oil ratio itself. The red numbers
marking all of the major interim lows in the ratio for the past four decades
correspond with the red numbers in the real oil and gold chart above. They
are included so it is easier to see what gold and oil happened to be doing
at each previous extreme similar to today's. It is amazing to now see
the gold/oil ratio at its lowest levels ever.

With an ounce of gold trading at only 7.7x the cost of a barrel of oil, we
have never before seen the gold/oil ratio this far out of whack. In each of
the five previous cases that major interim gold/oil ratio (GOR) lows were carved,
the ratio immediately mean reverted back away from those extremes. At worst
the GOR mean reverted back up near its average, and at best it mean reverted
far beyond and overshot to extremes on the other side, like a giant pendulum.

To better define GOR extremes, we overlaid this chart with the ratio's four-decade
average of 15.3 as well as standard deviation bands. They help us visually
see exactly how rare a particular GOR happens to be. Statistically the GOR
should be within +/-1 standard deviation from its average 68.3% of the time,
2 SDs 95.4% of the time, and 3 SDs a whopping 99.7% of the time.

At roughly 1.5 SDs below its mean today, the GOR has never been lower. Odds
are it is due to mean revert back up, probably in a fairly rapid fashion if
history is a valid guide. The ratio almost certainly will head back up to its
mean of 15.3, but it could move higher as well, to 20.3 at the first standard
deviation or even 25.3 at the second. Regardless of how far this mean reversion
runs, it will happen sooner or later as it is extraordinarily unlikely
that today's extreme GOR low can persist indefinitely.

In order for the GOR to mean revert, either the price of gold has to rise,
the price of oil has to fall, or both at once. The most conservative case for
the coming mean reversion is probably to assume both at once. Our original
real oil and gold chart above shows why. Oil's rise has been nearly vertical
as of late, so sooner or later a healthy
correction is inevitable in this secular oil bull. Meanwhile gold has only
reached real levels last seen in 1997 or so, thus it really ought to get moving
to catch up with oil.

As far as the oil-correcting component of the GOR mean reversion, oil will
probably bottom somewhere between its linear
support line and its key 200-day moving average. Oil's 200dma is currently
just above $46 and its linear support is approaching $38. We can split the
difference and make a $42 target for the next major interim low in crude oil.

Interestingly, fundamentals back up this target as well. Last week the CEO
of the massive Kuwait Petroleum Corporation, Hani Hussein, told Gulf News out
of Abu Dhabi that, "Prices will never [again] go under the $40 per barrel mark." The
usual reasons were cited, massive new crude-oil demand out of the rapidly industrializing
Asian giants including China and India. So even supply and demand fundamentals
as seen by elite OPEC insiders bear out a $40ish worst-case scenario in the
next oil correction.

So if $40 is indeed a floor for oil going forward as OPEC suspects, this gives
us a potential idea of where gold would have to climb to in order for the GOR
to mean revert as it ought to. If crude oil fell to $40 and the GOR merely
mean reverted right back to its 15.3 four-decade average, gold would need to
rally up to $612 to make this happen. If the GOR overshot its mean reversion
as it often does and went to the 20.3 +1 SD level, gold prices would rocket
up to $812 or so!

Thus, even if oil corrects dramatically and stays near $40 for some time to
come, gold prices would have to rise far higher from here to even see
a modest mean reversion or a common overshoot to one standard deviation above
the long-term GOR mean. Obviously you can make these numbers a lot more aggressive
if you choose a higher oil price or a greater mean reversion overshoot, but
even in the most modest scenario gold ought to absolutely thrive in the coming
years.

Just as a rubber band stretched near its breaking point can't continue stretching
forever, neither can the gold/oil ratio. Over the past 30 years the GOR ratio
has always mean reverted sharply, often due to a major gold rally, shortly
after it hit a major interim low. With today's all-time low GOR extreme of
7.7, odds are we are in for another major mean reversion in the GOR which could
move rapidly as the past ones have. If you want to game this possibility buy
physical gold, deploy long gold futures, or buy quality unhedged gold-producing
stocks.

Another way to measure the relationship between gold and oil is to consider
the gold cost of crude oil, or GCCO. Expressed by the number of ounces of gold
it takes to buy 100 barrels of oil, it shows the relative value of oil in terms
of real money, gold. Considered in this alternative light, oil is now the most
expensive it has ever been in gold terms! Like the extreme GOR low,
this extreme GCCO high is probably not sustainable either.

At 12.9 ounces per 100 barrels, the gold cost of crude oil is now at its highest
levels in history. The four-decade average is only 7.2, and the GCCO
is now just shy of being three standard deviations above the mean, truly
extraordinary territory. Note above that in each of the five previous cases
that the GCCO hit extreme highs it promptly fell like a rock and mean reverted
with a vengeance.

If we assume that the $40 per barrel minimum for oil will hold for technical
and fundamental reasons, we can also model just how high gold would have to
climb in order for the GCCO to mean revert in line with historical precedent.

At $40, 100 barrels of oil would cost $4000. If the GCCO mean reverts back
down to its long-term average of 7.2x as it has at least done after every
other extreme high in history, then gold would need to march up to $556.
If the GCCO overshoots down to one standard deviation below its mean, like
it often does, then the GCCO would hit 5.1. At $40 oil gold would have to rally
up to $784 to bring the gold cost of crude oil back into line in this latter
scenario.

Once again you can play with the numbers if you like. If oil does correct
down near $40, for example, it is not likely to stay there for long given the
rapidly growing world demand and the incredible difficulties involved in finding
and bringing new supplies online. After a few months of correcting, oil would
probably bounce back strongly and trade above $50. And $60 and beyond will
certainly be seen in oil's next
major bull-market upleg.

At $50 oil, a gold/oil ratio merely hitting its four-decade mean of 15.3 would
yield a gold target of $765. In this same $50 scenario the gold cost of crude
oil gold target at its 7.2 mean would be $694. And of course the higher oil
ultimately goes in its powerful secular bull, the higher the potential gold
targets rise. Regardless of what numbers you plug into these equations, gold
looks tremendously undervalued by every single measure.

The bottom line is the financial markets abhor extremes. The more extreme
that a long-term historic relationship becomes, the higher the probability
that it will experience a sharp reversion back to or through its mean. Ignoring
this tendency in the gold/oil ratio is as silly as the tech investors who foolishly
thought that tech stocks could go up forever in early 2000 regardless of earnings.
The inevitable mean reversions eviscerate those who scoff at history and believe
in New Eras.

In the past five years the gold bull has lagged the oil bull dramatically.
Oil demand is growing rapidly around the world and especially in Asia as half
the planet industrializes and lusts after a first-world lifestyle. Meanwhile
no new major oilfields can be found and it is getting more and more expensive
to maintain production levels from existing major fields. With relentlessly
growing demand and hopelessly tight supplies, oil's secular bull is almost
certain to power higher for years.

As oil marches higher, gold will inevitably follow sooner or later as it always
has. Indeed, once investors "discover" the huge potential of gold and vault
it into Stage Two of
its secular bull, gold will surge and outperform oil long enough to bring these
key ratios back into line. Regardless if oil corrects, flatlines, or continues
higher, the target gold levels necessary for these ratios to mean revert are
far higher than today's cheap gold prices.

If you want to ride this highly probable gold/oil ratio mean reversion, the
best way to do it is to get long gold somehow. You can buy physical
gold coins if you are really conservative. You can buy gold futures if
you are a speculator trafficking in that world. You can also leverage the gold
surge indirectly by buying shares of elite quality unhedged gold-mining
companies, a very profitable strategy we have been using at Zeal for the
entire gold bull now.

Our acclaimed Zeal Intelligence monthly
newsletter outlines our ongoing gold bull strategy as well as actual real-world
gold-stock trading recommendations when appropriate. If the gold/oil ratio
indeed mean reverts as history suggests it ought to, we will be blessed with
some fantastic gains in our gold-stock portfolio. Please
join us today to capitalize on this dazzling and rare opportunity to ride
a gold/oil ratio mean reversion.

With the gold/oil ratio at an all-time low and the gold cost of crude
oil at an all-time high, conditions have never been riper for a powerful
mean reversion. And as tight as global oil supply and demand fundamentals are,
the only practical way this mean reversion can be executed is via a massive
new gold upleg.

If you have questions I would be more than happy to address
them through my private consulting business. Please visit www.zealllc.com/financial.htm for
more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that
I am not able to respond to comments personally. I WILL read all messages though,
and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst,
publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis
of markets, geopolitics, economics, finance, and investing delivered from an
explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for
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